Recovery funds: can fund managers pick turnaround firms?

Which fund managers have the capability to identify turnaround stories and how have recovery funds fared during recent bull markets?

What recovery funds aim to do is invest predominantly in the shares of companies that, at the time of investment, are out of favour with the stock market. The fund manager identifies hidden value in the fact that a sound (and sometimes new) management team is resolutely trying to turn the business around.

Often the fund manager is taking a longer-term view as the turnaround may be far from imminent. They are buying out-of-favour stock cheaply in the anticipation that the share price will rebound significantly when measures to improve the business start to show on the balance sheet.

The objective is to buy into this recovery potential and then sell for a tidy profit when this potential is realised.

Global brand turnarounds

Not all failing companies can be turned around, but there are plenty of good examples of companies that have seen their brand and profits recover after some tough times. Even global giants such as Apple have fallen from grace in the past.

Steve Jobs revolutionised Apple Credit: Shutterstock

Companies make mistakes and in Apple’s case it was when the board members lost faith in the company’s founder Steve Jobs and removed him from his post as CEO in 1985. Following Jobs’ departure, innovation within Apple struggled and sales dropped markedly.

When he returned as CEO in 1997, Apple was staring at bankruptcy. He not only steadied the ship but went on to transform the digital music and mobile phone industries with the introduction of the iPod, the iPhone and iTunes.

Not every turnaround story is going to be as dramatic and culturally significant as Apple, but it shows how a change in leadership can turn a failing business into a market-leading one.

Unloved companies

For fund managers, turnarounds don’t always happen. The new CEO brought in to move the business forward may be head-hunted by a rival. A merger that was much anticipated, could fail to materialise.

In some cases, unloved stocks remain just that. But the benefit of a portfolio of turnaround possibilities is that you don’t need every selection to be correct to produce a good return.

It’s arguable that a bull market is not the best time to find unloved or under-valued stocks. When markets are more bearish and there are indiscriminate sector sell-offs, there are opportunities to buy stocks of businesses (caught up in the negative sentiment) at a good discount.

In reality, there are always companies that offer potential despite weak points in their sector or business model – the onus is on finding them.

Fund manager skills

Some recovery funds have fared better than others in recent years and that is not overly surprising since in this ‘sector’ it is not always a case of comparing like with like.

As Justin Modray, IFA with Candid Financial Advice, explains: “Recovery funds are a clear example of where the skill and approach of the fund manager really matter. Despite generic ‘recovery’ and ‘special situations’ titles, the way in which these funds invest can vary widely.”

“For example, some managers focus primarily on smaller companies, while others focus on larger. And the geographical exposure and types of recovery situation vary too.”

Fund managers versus armchair investors

In terms of picking out recovery stories, do fund managers have an advantage over armchair investors?

Modray says that in theory fund managers are better placed than individuals to identify turnaround stories, since it’s their full-time job and they have significant resources at their disposal, but in practice they may fail to deliver.

“The M&G Recovery fund is a prime example where a ‘star’ manager has consistently underperformed for many years, although it has done a little better over the last 12 months.”

Indeed, the M&G fund is one of the most well-known funds in this space, but it has only just started to recover ground after a torrid few years. Fund manager Tom Dobell takes a long-term view with a typical holding period of five years or more. As with many recovery/special situation funds, investors are required to be patient.

M&A pick up

Dobell explains that since Spring 2016, the environment has been more to his liking with better stock selection opportunities across different market caps. He also points to an improving outlook in the M&A space which should provide an ongoing boost to performance.

“M&A is a key part of recovery fund performance. In recent years, there have been slim pickings in this area but from 2016 we started to see more activity.” The fund has benefited from exposure to major takeover targets of late, for instance parcel firm UK Mail.

Despite the improved performance of Dobell’s fund, it is not on Modray’s preferred list. “My favoured fund in this area is Marlborough Special Situations, run by Giles Hargreave. It focuses on smaller companies and has a great long-term track record.”

Best funds

The Marlborough fund consistently features in Hargreaves Lansdown's Wealth150 list of what the broker believes are the best funds in each IMA sector.

According to Hargreaves Lansdown, the fund's outperformance of the FTSE Small Cap index has been exceptional. Strong stock picking has been the main driver of this performance, according to HL’s analysis.

“Smaller companies often fall out-of-favour with investors in times of market stress, such as 2008, but this fund has historically managed to shelter investors from the worst of these falls.”

“This has been assisted by the tendency of the fund manager to maintain a portion of the portfolio in cash at specific points in time.”

Recovery or special situation funds may not be suitable for all – for instance investors in retirement who are focussed on lower-risk and regular income. But for others looking for a diverse investment portfolio, sticking some cash in recovery funds could give a welcome long-term return.

Capital Com SV Investments Limited is a Cyprus Registered Company with Company Registration Number HE 354252. It is a regulated Cyprus Investment Firm, licensed by the Cyprus Securities and Exchange Commission (CySEC), under license number 319/17.Capital Com SV Investments is authorised to provide investment services in more than 20 European countries.It is an Investment Firm following the implementation of the Markets in Financial Instruments Directive (MiFID).

The information found on this website isn’t applicable to residents of the USA or Belgium and shall not be used or distributed in any country or jurisdiction where it goes against domestic legislation and regulations.

All content on this website belongs to Capital.com, unless stated otherwise. Any of the website content that belongs to Capital.com is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License. Whenever shared or adapted the content must be accompanied with appropriate credit to Capital.com with links or hypertexts leading to Capital.com and the initial page of the content's publication on Capital.com. All third-party owned content appearing on this website is subject to the rights of their respective owners and the applicable distribution rules.